Iceland - Cuts Watch December 2011

In the 2000s the economy of Iceland grew rapidly led by a surge in financial activity. In 2008 the three major banks which had been at the centre of this boom collapsed, leading to a devaluation of the currency and a sharp rise in national debt. The government asked for a loan package from the IMF. The terms of this deal included a cut in public spending of 16% of GDP. Following strikes and demonstrations, the government resigned and was replaced by a red-green coalition in 2009, which introduced a smaller package, which was still equivalent to 12% of GDP. Part of this was achieved through higher taxes, and the package was designed to affect the poorest least, but part also through cuts in spending on pensions, child benefit and healthcare. Due to these measures and the fall in the value of currency, Icelandic households experienced a fall in real income of about 30%.

However, unlike other countries, Iceland allowed the banks themselves to collapse, with their creditors bearing the losses. Account-holders were given priority over creditors – it is expected that all depositors will in the end receive the full value of their deposits. The state created and capitalised new banks, to which they transferred Icelandic assets at a negotiated ‘fair price’. There was no ‘socialisation’ of the banks’ losses. Governments of other countries including the UK and Netherlands demanded that all their citizens who had opened accounts with the collapsed banks should be repaid in full by the Icelandic government, but this was rejected by massive majorities when put to a referendum in Iceland. In effect Iceland allowed the banks to collapse, and did not transfer the losses. It also introduced capital controls, to prevent volatile movement of finance.

By 2011, the Icelandic government was being praised by economists for refusing to socialise the losses, for imposing capital controls, and for enabling a recovery to start on the least painful terms.